Chapter Five

Security Analysis

Introduction
Generally, all securities are associated with risks. The actual return an investor receives from
the securities is related to the risk. So, it becomes necessary for investor to analyze the
securities from the view point of their prices, returns and risks. This analysis is useful in
understanding the fluctuations of prices of securities and the behavior pattern of the market
before one decide to invest in securities.
In order to make a rational and scientific investment decision, an investor has to evaluate a lot
of inform as to the part as well as the expected future performance of companies, industries
and the economy as a whole in advance such evaluation or analysis is known as fundamental
analysis.
There are various approaches to security analysis which are presented Gas follows:
1. Fundamental analysis
a. Macro-economic analysis
b. Industry analysis
c. Company analysis
2. Technical analysis

5.1. Macro-economic Analysis

The performance of a company depends much on the performance of the economy. If the
economy is BOOM, the industries and companies in general said to be prosperous. On the
other hand, if the economy is in RECESSION, the performance of companies will be
generally poor. Investors are interested in studying those economic varieties, which affect the
performance of the company in which they proposed to invest. An analyzed of those
economic variables would give an idea about future corporate earnings and the payment of
dividends and interest to investors.
We shall now discuss some of the key economic variables that can investor must monitor as
part of this fundamental analysis:
(1)GDP
(2) Savings and Investment
(3) Inflation
(4) Agriculture
(5) Rates of Interest
(6)Govt. Revenue, Expenditure & Deficits
(7) Infrastructure
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(8) Monsoon
(9) Political Stability
(1) GDP
GDP indicates the rate of growth of the economy. It represents the aggregate value of goods
and services produced in the economy. The growth rate of economy points out the prospects
for the industrial sector and the return investors can expect from investment in shares. The
higher growth rate is more favorable to the stock market.
(2)Savings and Investment
Savings and investments represent that portion of GNP which is saved and invested. It is
obvious that growth requires investment which in turn requires substantial amount to
domestic savings. Stock market is a channel through which the savings of the investors are
made available to the corporate bodies.A higher level of savings and investments, accelerates
the pace of growth of the stock market.
(3) Inflation
Inflation has considerate impact on the performance of companies. Higher rates of inflation
upset business plans and the purchasing power in the hands of consumers. This will result in
lower demand for products. Thus high rates of inflation in an economy are likely to affect the
performance of companies adversely. However, industries and companies prosper during
periods of low inflation. Hence an investor has to evaluate the inflation rates prevailing in
the economy currently as well as the trend of inflation likely to prevail in the future.
(4) Rates of Interest
The cost and availability of credit for companies are determined by the rates of interest
prevalent in an economy. A low interest rate stimulates investment by making credit available
easily and cheaply. As a result cost of finance for companies decreases which assures higher
profitability. On the other hand, higher interest rates result in higher cost of production,
which may lead to lower profitability and lower demand. Hence an investor has to consider
the interest rates prevailing in the economy and evaluate their impact on the performance and
profitability of the companies.
(5) Govt. Revenue, Expenditure & Deficits
Government is the largest investor and spender of money. So the trends in government
revenue expenditure deficits have a significant impact on the performance of industries and
companies. So the investor has to evaluate these carefully to assess their impact on his
investments.
(6) Infrastructure Facilities
The development of an economy very much on the availability of infrastructure. It includes
electricity, roads and railways, communication channels, sound banking and financial sectors
etc. The availability of infrastructural facilities affects the performance of companies. While
inadequate infrastructure leads to inefficiencies, lower productivity, wastage and delays and

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vice versa. Thus an investor should assess the status of infrastructural facilities available in
the economy before finalizing his investment avenues.
(7) Monsoon and Agriculture
Agriculture is directly and indirectly linked with the industries. Ex:-Sugar, Cotton, Textile
and Food processing industries depend upon agriculture for raw-material. A good monsoon
leads to higher demand for input and results in bumper crop. This would lead to good spirit in
the stock market. When the monsoon is bad, agricultural and power production would suffer.
They cast a shadow on the share market.
(8) Political Stability
A stable political environment is necessary for steady and balanced growth. No industry or
company can grow and prosper when the country is passing through political instability. The
long term economic policies are needed for industrial growth. Stable policies can be framed
only by stable political systems.

5.2. Industry Analysis

Industry analysis indicates to an investor whether the industry is a growth industry or not. It
gives an investor a choice of the industry in which the investments should be made. Industry
analysis refers to an evaluation of the relative strength and weakness of particular industries
which can be divided in to three parts, viz.,
1. Life cycle of an industry
2. Characteristics of an industry
3. Profit potential of an industry
1. Life cycle of an industry
Marketing experts believe that each product has a life cycle. In the same way industry is also
said to have a life cycle. They are
a. Pioneering Stage:
Technology and product are newly introduced. There would be severe competition and only
fittest companies survive this stage. The producers try to develop brand name, differentiate
the product and create a product image. The severe competition often leads to the change of
position to the firms in terms of market shares and profit. In this situation, it is difficult to
select companies for investment because the survival rate is unknown.
b. Growth and Expansion stage:
This stage stars with the appearance of surviving firms from the pioneering stage. Companies
in this stage stabilize their prices, develop a market of their own and follow their own
strategies. Ultimately, by showing their competitive strength, the firms are able to maintain
their position in the market. This is the best time for the investor to make an investment in
companies passing through the expansion stage. The investors can get high returns because
demand exceeds supply of the product.
c. Stagnation Stage:

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In this stage the growth of the industries Stabilizes. Moreover, sales increases at slower rate.
The industry realizes that it cannot expand further. To keep going, technological innovations
in the production process and products should be introduced. So, the companies who have
taken note of the arrival of stagnation stage have to change their course of action. Likewise,
investors too should evaluate their investment in such industry on a continuous basis.
d. Decay stage:
In this stage, demand for the particular product and the earnings of the companies in the
industry decline. The specific future of the declining stage is that even in the boom period the
growth of the industry would be low and decline at a higher rate during the recession. It is
better to avoid investing in the shares of the low growth industry even in the boom period.
Investment in the shares of these companies leads to erosion of capital.
Characteristics of an industry
In an Industry Analysis the analyst should consider a number of key characteristics:
 Relationship between Demand & supply
 Nature of the product
 Nature of the computation
 Growth of the industry
 Labor
 Government policy
 Availability of Raw Material
 Research and development
Profit potential of an industry
It depends on the following factors:
(i) Threat new entrants:
New entrants inflate cost, push down the prices and reduce profitability. An industry which is
well protected from the entry of new firms would be ideal for investment.
(ii) Competitions among existing firms:
The firm competes with each other on the basis of price, quality, promotion, service,
warranties and so on. If the competition between the firms in an industry is strong average
profitability of the industry may be discouraged.
(iii) Pressure from substitute products:
Each firm in an industry faces competition from other firms in the same industry producing
substitute products. Ex:- Sony T.V, Samsung T.V etc..Substitute products may affect the
profit potential of the industry badly. The pressure from the substitute products is found to be
high under the following circumstances:

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(a) When the price of the products is attractive
(b) When the cost for the prospective buyers to switch over to a substitute product is
minimum.
(c) When the substitute products are earning greater profits.
(iv) Bargaining power of buyers:
Buyers can bargain for price reduction asks for better quality and better service. The
bargaining power of a buyer group is said to be high under the following conditions:
(a) If its capacity to buy is more than the capacity of the seller to sell.
(b) If the cost of the switch over to a substitute product is low.

5.3. Company Analysis

One analysis of the economy and the market has indicated a favorable time to invest in
common stocks and industry analysis has been performed to find those industries that are
expected to perform well in the future, it remains for the investor to choose promising
companies within those industries. The last step in top-down fundamental analysis, therefore,
is to analyze individual companies.
Fundamental analysis at the company level involves analyzing basic financial variables in
order to estimate the company’s intrinsic value. These variables include sales, profit margins,
deprecation, the tax rate, source of financing, asset utilization, and other factors. Additional
analysis could involve the firm’s competitive position in its industry, labor relations,
technological changes, management, foreign competition, and so on.
The end result of fundamental analysis at the company level is the data needed to calculate
the estimated or intrinsic value of stock using one or more valuation model.
Investors can use the dividend discount model (DDM) to value common stocks for
companies that maintain relatively stable dividend payments. In some circumstances it is
reasonable to assume that the dividend growth rate for a particular company will be
approximately constant over the future, which allows us to use the constant-growth version of
the DDM.
Intrinsic value = Po = D1/k-g
Where;
Po = the estimated value of common stock today
D1 = the expected dollar dividend to be paid next period
K = the required rate of return
g = the estimated future growth rate of dividends expected to continue indefinitely
Alternatively, the earning multiplier model could be used. Intrinsic value is the product of the
estimated earnings per share (EPS) for next year and the multiplier or forward P/E ratio
(Po/E1), as shown in the following equation.

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Intrinsic value = Po= estimated EPS x Po/E1 ratio
Using either DDM or earning multiplier, we can compare a stock’s calculated intrinsic value
to its current market price. If the intrinsic value is larger than the market price, the stock can
be considered undervalued- a buy. If intrinsic value is less than the market price, the stock is
considered overvalued and should be sold if owned, and avoided or sold short if not owned.

Analyzing a company’s profitability

At the company level, EPS is the culmination of several important factors. Accounting
variables can be used to examine these determining factors by analyzing key financial ratios.
Analysts examine the components of profitability in order to try to determine whether a
company’s profitability is increasing or decreasing and why. Primary emphasis is on the
return on equity (ROE) because it is a key component in determining earnings and dividend
growth.
Note that, EPS= ROE x book value per share, which demonstrate the relationship between
EPS and ROE. Since book value typically changes rather slowly, ROE is the primary variable
on which to concentrate.
ROE can be determined using the following equation:
ROE = Net Income/ Shareholder’s equity

5.4 Analyzing return on equity

The ROE is the end result of several important variables that are often analyzed by what is
referred to as the DuPont system analysis. The idea is to decompose the ROE into its critical
components in order both to identify adverse impact on ROE and to help analysts predict
future trends in ROE.
Different combinations of financial ratios can be used to decompose ROE. One approach is to
use a multiplicative relationship that consists of five financial ratios, all multiplied together to
produce ROE. The first four can be multiplied together to determine return on asset (ROA),
an important measure of company’s profitability. The five financial ratios are: (1) EBIT
efficiency, (2) asset turnover, (3) interest burden, (4) tax burden, and (5) leverage.
i. A key component of a company’s profitability is its operating efficiency, which is
unaffected by interest charges, taxes, or the amount of debt financing used by a
company to finance its assets (leverage). To determine operating efficiency, analyze
its components which are operating income (EBIT) and asset turnover.

EBIT efficiency = EBIT/ sales

ii. Asset turnover is a measure of efficiency. Given some amount of total assets, how
much can be generated in sales? The more sales per dollar of assets the better is for a
firm, since each dollar of assets has to be financed with a source of funds bearing a
cost. The firm may have some assets that are unproductive, thereby adversely
affecting its efficiency.

Asset turnover = sales/Total asset

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 iii. Next, consider the impact of interest charges, interest expense for most companies is
an important tax-deductable item. The “interest burden” can be calculated as the ratio
of pre-tax income to EBIT.

Interest burden = Pre-tax income/ EBIT

iv. The last variable that must be considered as part of the analysis of a company’s return
on assets is the tax burden. To calculate this amount, divide net income by pre-tax
income.

Tax burden = Net income/Pre-tax income

Return on asset (ROA) can now be calculated from these variables that have
important impacts on a company’s return on assets:
ROA = (EBIT/ sales) x (sales/Total asset) x (Pre-tax income/ EBIT) x (net
income/Pre-tax income)
ROA is a fundamental measure of firm profitability, reflecting how effectively and
efficiently the firm’s assets are used.
v. Finally, the effect of leverage must be considered. The leverage ratio measures how
the firm finances its assets.

Leverage = Total assets/ Shareholders’ equity

Finally, the last step in the ROE analysis is to relate ROA and leverage
ROE = ROA x leverage

Estimating the internal (sustainable) growth rate

An important part of company analysis is the determination of a sustainable growth rate in
earnings and dividends. Such a growth rate estimate can be used in the dividend discount
model or to estimate an appropriate P/E multiple.
What determines the sustainable growth rate? The internal growth rate of earnings or
dividends, g, can be determined as the product of the ROE and the retention ratio which is
calculated as 1.0 minus the dividend payout ratio.
g= ROE X (1-payout ratio)
The intuition behind this measure is that growth in earnings (and dividends) will be positively
related to the amount of each dollar of earnings reinvested in the company (as measured by
the retention ratio), times the return earned on reinvested funds (ROE).
A weakness of this approach is its reliance on accounting figures that are based on book
values and the accrual method of accounting. As a result, they may not always serve reliable
proxies for market values and cash flows.

Earnings estimates
The EPS that investors use to value stocks is the future (expected) EPS. Current stock price is
a function of future earnings estimates and appropriate P o/E1 ratio, not the past. If the

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investors knew what the EPS for a particular company would be next year, they could
achieve good results in the market.
When performing fundamental security analysis using EPS an investor needs to:
i. Know how to obtain an earnings estimate

Among the most obvious source of earnings estimates are security analyst, who
make such forecasts as part of their job.
An alternative method of obtaining earnings forecasts is the use of mechanical
procedures such as time series models. In deciding what type of model to use,
some of the evidence on the behaviour of earnings over time should be
considered. Time series analysis involves the use of historical data to make
earnings forecasts. The model assumes that the future will be similar to the past.
The series being forecast, EPS is assumed to have trend elements, an average
factors, and error. The moving average technique is a simple example of the time
series model for forecasting EPS.
ii. Consider the accuracy of any earnings estimate obtained

iii. Understand the role of earnings surprises in impacting stock prices

The important point about EPS in terms of stock prices is the difference between
what investors in general are expecting the EPS to be and what the company
actually reports. Unexpected information about earnings calls for investors to
revise their expectations about the future and therefore an adjustment in the price
of stock. A favourable earnings surprise, in which the actual earnings exceed the
market’s expectation, should bring about an adjustment to the price of the stock as
investors alter their beliefs about the company’s earnings. Conversely, an
unfavourable earnings surprise should lead to a downward adjustment in price; in
effect, the market has been disappointed in its expectation.

Useful information for investors about earnings estimates

Summarizing our discussion about earnings forecasts, we can note the following useful
information about the role of earnings forecasts in selecting common stocks:
i. Earning reports are a key factor affecting stock prices.

ii. Surprises occur because analyst estimates are often considerably off target.

iii. There appears to be a lag in the adjustment of stock prices to earnings surprises.

iv. The best guidelines to surprise are revisions in analyst estimates.

v. One earnings surprise tends to lead to another.

The P/E ratio

The other half of the valuation framework in fundamental analysis is the price/earnings (P/E)
ratio, or the earning multiplier. The P/E ratio indicates how much per dollar of earnings

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investors currently are willing to pay for a stock, that is, the price of each dollar of earnings.
In a sense, it represents the market’s summary evaluation of company’s prospect.

Determinants of the P/E ratio

P/E ratio is conceptually a function of three factors, as expressed in the following equation:
P0/E1 = (D1/E1)/k-g
Where;
D1/E1 = the expected dividend payout ratio
k= the required rate of return for the stock
g= expected growth rate in dividend
Investors attempting to determine the P/E ratio that will prevail for a particular stock should
think in terms of these three factors and their likely changes. Each of these considered below.

The dividend payout ratio

Dividends are clearly a function of earnings. The relationship between these two variables,
however, is more complex than current dividends being a function of current earnings.
Dividends paid by corporations reflect established practices (i.e. previous earnings level) as
well as prospects for the future (i.e. expected future earnings).
Dividends are usually not reduced until and unless there is no alternative. In addition, they
are generally not increased until it is clear that the new, higher level of dividends can be
supported.
The P/E ratio can be expected to change as the expected dividend payout ratio changes. The
higher the expected payout ratio, other things being equal, the higher the P/E ratio. However,
“other things” are seldom equal. If the payout rises, the expected growth rate in earnings and
dividends, g, will probably decline, thereby adversely affecting the P/E ratio. This decline
occurs because less funds will be reinvested in the business, thereby leading to a decline in
the expected growth rate, g.

The required rate of return

As we know, the required rate of return, k, is a function of the riskless rate of the riskless rate
of return and risk premium.
k= RF + RP
The riskless rate of return is usually proxied by the short-term government T-bill rate. The
risk premium is the additional compensation demanded by risk-averse investors before
purchasing a risky asset such as a common stock.
As alternative to using CAMP to estimate “k”, many analyst estimate the return on a
company’s stock using the bond yield plus risk premium approach, which employs the
equation below:
k= the company’s bond yield + equity-bond risk premium

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In this equation, the analyst simply finds out the prevailing yield on a company’s long-term
bonds that are outstanding and adds a risk premium to compensate investors for the additional
risk associated with holding a company’s equity versus holding its debt. Similar to the risk
premium used in the CAPM model, this risk premium will vary across firms (being higher for
riskier firms), and will also vary through time (being higher during periods of greater
uncertainty).
Based on the above two equations, the following tow statements can be made about a
company’s required rate of return:
 Other things being equal, if the risk-free rate, RF, rises (or bond yields rise), the
required rate of return, k, will rise.

 Other things being equal, if the risk premium rises as a result of an increase in risk
(which could caused by an increase in business risk, financial risk, or other risks), k
will rise.

As we learned in financial management course, the relationship between k and the P/E ratio is
inverse: other things being equal, as k rises, the P/E ratio declines: as k declines, the P/E ratio
rises. Because the required rate of return is a discount rate, P/E ratio and discount rates move
inversely to each other.

The expected growth rate

The third variable affecting the P/E ratio is the expected growth rate of dividends, g. we know
that g= retention ratio X ROE, making the expected growth rate a function of the return on
equity and the retention rate. The higher either of these variables is, the higher g will be, all
other things being equal. What about the relationship between g and P/E? P/E and g are
directly related: the higher the g, the higher the P/E ratio, and other things being equal.
Investors are generally willing to pay more for a company with expected rapid growth in
earnings than for one with expected slower growth in earnings. A basic problem in
fundamental analysis, however, is determining how much more investors should be willing to
pay for growth. On other words, how high should the P/E ratio be? There is no precise
answer to this question. It depends on such factors as the following:
 The confidence that investors have the in the expected growth. For some companies
investors may be well justified in expecting a rapid rate of growth for the next few
years because of previous performance, management’s ability, and the high estimates
of growth described in investment advisory service. This may not be the case for
another company, where, because of competitive inroads and other factors, the high
growth prospects are at great risk.

 The reasons for the earnings growth can be important. Is it the result of great demand
in the market place or of astute financing policies that could backfire if interest rate
rises sharply or the economy enters a severe recession? Is growth the result of sales
expansion or cost cutting? DuPont analysis is designed to provide insight into these
issues.

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5.4. Technical analysis
It involves the examination of past market data such as prices and the volume of trading,
which leads to an estimate of future price trends and makes a buy/sell decision based on those
factors.
Fundamental analysts use economic data that are usually separate from the stock or bond
market,
Technical analyst believes that using data from the market itself is a good idea because “the
market is its own best predictor.”
Technical Analysis Fundamental Analysis
Predicts short-term price movements Establishes long-term values
Focuses on internal market data Focuses on fundamental factors
Appeals to short-term traders Appeals to long-term investors
Assumptions of Technical Analysis
 The market value of any good or service is determined solely by the interaction of
supply and demand.
 Supply and demand are governed by numerous factors.
 Disregarding minor fluctuations, the prices for individual securities and the overall
value of the market tend to move in trends, which persist for appreciable lengths of
time.
 Prevailing trends change in reaction to shifts in supply and demand relationships.
These shifts, no matter why they occur, can be detected sooner or later in the action of
the market itself.
Advantages of Technical Analysis
1. Most technical analysts admit that a fundamental analyst with good information, good
analytical ability, and a keen sense of information’s impact on the market should achieve
above-average returns.
 However, this statement requires qualification.
 But such type of qualification does not require in technical analysis.
2. According to technical analysts:
 Fundamental analysts can experience superior returns only if they obtain new
information before other investors and process it correctly and quickly.
 But Technical analysts do not believe the vast majority of investors can consistently
get new information before other investors and consistently process it correctly and
quickly.
3. Technical analysis is not heavily dependent on financial accounting

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  The technician points out several major problems with accounting statements:
• They lack how capital is utilized by product line and customers
• Many psychological factors and other non quantifiable variables do not appear in
financial statements
• Application of different methods of GAAP.
But most of the data used by technicians, such as security prices, volume of trading, and other
trading information, is derived from the stock market itself.
4. Also, a fundamental analyst must process new information correctly and quickly to derive
a new intrinsic value for the stock or bond before the other investors can.
Technicians, on the other hand, only need to quickly recognize a movement to a new
equilibrium value for whatever reason.
Challenges to Technical Analysis
1. Challenges to Technical Analysis Assumptions: -
 Prices moves in trends but almost all the studies testing the EMH (weak-form) using
statistical analysis have found that prices do not move in trends based on statistical
tests of autocorrelation and runs.
2. Challenges to Technical Trading Rules: -
 An obvious challenge to technical analysis is that the past price patterns or
relationships between specific market variables and stock prices may not be repeated.
As a result, a technique that previously worked might miss subsequent market turns.
 Another problem with technical analysis is that the success of a particular trading rule
will encourage many investors to adopt it. It is contended that this popularity and the
resulting competition will eventually neutralize the technique.
 When we examine specific trading rules, they all require a great deal of subjective
judgment. The same price pattern may arrive at widely different interpretations of
what has happened and, therefore, will come to different investment decisions.
 In connection with several trading rules, the standard values that signal investment
decisions can change over time

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